Tax Accounting Methods for Construction Contractors

Construction contractors default to the percentage of completion method for any job that starts in one tax year and finishes in another, but two statutory exemptions let smaller firms and home builders use simpler tax accounting methods, including the completed contract method, cash basis, or accrual. The choice among these methods for construction contractors determines when income hits the return, not just how much tax is owed. On a multi-year job, that timing difference can be worth a lot.

The rules sit in Section 460 of the Internal Revenue Code, which governs long-term contracts. A contract is “long-term” for tax purposes if it involves building, constructing, or rehabilitating real property and won’t be finished in the same tax year it started.¹ Everything below flows from whether your contracts meet that definition and whether you qualify for an exemption from the default rule.

How the Percentage of Completion Method Works

Under the percentage of completion method (PCM), you report contract income as the job progresses rather than when you bill or get paid. The measurement is cost-to-cost: divide costs incurred to date by total estimated costs, then apply that percentage to the total contract price. The result is your revenue for the year.¹

An example makes this concrete. On a $2 million contract with $1.5 million in estimated total costs, if you’ve spent $600,000 to date, you’re 40% complete and report $800,000 in revenue for the period.

The IRS uses cost-to-cost because it ties reported income to actual work performed, not to billing milestones or cash received. That prevents contractors from collecting large progress payments early in a job and pushing the tax bill into a later year. For large commercial contractors, PCM is not optional. It applies by default unless a specific exemption fits.

Who Can Skip PCM

Federal law carves out two exemptions from the PCM requirement. If either fits your contract, you have a real choice of method.

Small Contractor Exemption

A contract escapes PCM if two conditions are both met:

Your average annual gross receipts over the prior three tax years do not exceed the inflation-adjusted threshold, which is $32 million for 2026.²
You estimate the project will finish within two years of the start date.¹

Contractors who clear both bars can use the completed contract method, cash-basis accounting, or the accrual method for the exempt contracts. The completed contract method is often the most tax-favorable option: no income or expenses are reported until the job reaches final completion and acceptance. On a qualifying two-year project, the entire gross profit lands on the return in the year the work wraps up rather than being spread across both years.

Home Construction Contract Exemption

A separate exemption applies to home construction contracts regardless of the contractor’s size. A project qualifies if at least 80% of the estimated total contract costs relate to building or improving dwelling units in structures containing four or fewer units. Each townhouse or rowhouse counts as its own building.¹

Larger residential projects with more than four units per building get partial relief. On those jobs, 70% of the contract is reported under PCM and the remaining 30% under the completed contract method. This split applies only to residential work above the four-unit line; commercial contractors don’t get access to the 70/30 hybrid.

Cash Basis or Accrual: The Choice Inside the Exemption

Contractors who qualify for the small contractor exemption still have to pick between cash-basis and accrual-basis accounting. The difference is timing. Under cash basis, income is recorded when payment arrives and expenses are deducted when paid. Under accrual, income is recorded when you earn the right to receive it and expenses when the obligation is incurred, regardless of when cash changes hands.³

Cash basis is usually more favorable for small contractors because it lets you control the timing of income by accelerating or delaying billing at year-end. If a December invoice would push you into a higher bracket, you can hold it until January. Accrual doesn’t offer that flexibility. Income is recognized when earned, whatever the billing schedule says.

Retainage

Retainage complicates the picture because owners routinely hold back 5% to 10% of each progress payment until final completion. The tax treatment tracks whichever method you use:

Under PCM, retainage is part of the total contract price in the cost-to-cost formula, so it is pulled into income as work progresses even though the cash hasn’t arrived.
Under the accrual method outside PCM, retainage generally isn’t taxable income until the performance condition is met and the right to receive the payment becomes fixed.
Under cash basis, retainage doesn’t count as income until you actually receive it.

For a contractor sitting on hundreds of thousands of dollars of unreleased retainage at year-end, cash basis can defer a significant tax bill that PCM would recognize immediately.

The Look-Back Method

PCM depends on estimates, and estimates miss. The look-back method exists to true things up. When a PCM contract finishes, you recalculate what each year’s reported income should have been using actual costs rather than projections. If you underreported income in earlier years, you owe interest to the IRS on the difference. If you overreported, the IRS owes you interest.⁴

The calculation is done on Form 8697, filed for the tax year the contract is completed and for any later year in which the contract price or costs are adjusted. Two carve-outs keep smaller jobs out of the process:

De minimis contract exemption: the contract was completed within two years and the total price is less than $1 million (or less than 1% of average annual gross receipts over the prior three years, whichever is smaller).
10% income variance election: the contractor can skip look-back if cumulative income reported in prior years falls within 10% of the recalculated amount using actual costs.

Home construction contracts exempt from PCM are also generally outside the look-back rules. For contractors on PCM, wide swings between estimated and actual costs carry a real cash cost in the form of interest owed.

Changing Accounting Methods

Switching methods is not something you can do quietly on next year’s return. A change requires filing Form 3115 with the IRS, and it typically produces a catch-up adjustment under Section 481(a) that spreads the income impact of the switch over four years.⁵

The common triggers are practical ones. A growing contractor crosses the gross receipts threshold and has to move from cash to accrual with PCM. A shrinking contractor drops below the threshold and wants to switch the other direction. A firm starts taking on jobs longer than two years and loses access to the completed contract method for those contracts even if it stays under the receipts cap. In each case, Form 3115 is the mechanism, and the Section 481(a) adjustment is the price of admission.

Putting It Together

The decision tree is short. If your average gross receipts exceed $32 million or the contract will run longer than two years, PCM applies unless the job qualifies as a home construction contract. If you’re under the receipts threshold and the job will finish inside two years, you can use the completed contract method, cash basis, or accrual, and cash basis with the completed contract method is usually the most tax-favorable combination. If you’re building homes in structures of four units or fewer, the home construction exemption gets you the same options without regard to your size. And whatever you pick, changing later means Form 3115 and a spread-out catch-up.

1
Office of the Law Revision Counsel. 26 USC 460 – Special Rules for Long-Term Contracts
2
Internal Revenue Service. Revenue Procedure 2025-32
3
Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
4
Internal Revenue Service. About Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts
5
Internal Revenue Service. About Form 3115, Application for Change in Accounting Method